Why VCs don't invest in Games.

Having just spent the better part of the last year walking up and down Sand Hill road asking Venture Capitalists to fund an online game company before returning to EA, I found this article to be very timely. It's a somewhat ranty piece following on the heels of this week's Video Game Investor Conference held up in San Francisco. Here are some highlights:

Video games are an attractive market. But there seems to be a lot of fear about investing in them. Venture capitalists have shied away from them, in part because investments in early stage development companies carry huge risks. It’s a hit or miss business, and venture capitalists have no particular skill at picking those hits. They’re much more comfortable with investments in technologies, but that skews them in a certain direction.

If you've followed the MMP game space then you know that it is the exception to the rule. Some companies like Turbine and Perpetual started with seed round investments while others like Mythic and Funcom took later stage money.

Online games is one area where they will invest, as evidenced by deals that Turbine Entertainment and Mythic Entertainment have struck with the VCs. Turbine raised $30 million this year in a second round to fund titles such as Middle Earth Online and Dungeons and Dragons Online. To date, Turbine has raised almost $50 million. Mythic raised $20 million. Perpetual Entertainment raised $6.5 million last fall to do an online Star Trek game. Funcom, developer of Anarchy Online, just raised $6 million. With those companies there was some core technology that was crucial to success. In case their games bombed, the companies could always auction off that core technology to someone else.

Auctioning off the core tech of a 'failed' game is more of a myth. The game industry is very much a N.I.H. environment. If you've got a hot engine powering a top game like Quake you might be able to license it to another development team. If your tech is from some belly-up startup that no-one has heard of and worse yet doesn't have a hit game built on-top of it you are not going to find many takers.

Here is another interesting bit:

Capital Entertainment Group (CEG)started up in May, 2002, with four game veterans, including two of the creators of the original Xbox. But after raising some seed money, they found they couldn’t raise the $25 million plus that they needed to fund several big games, which would have allowed them to spread their risks out for investors. They were going to be producers, who took the ideas of game developers and escorted them through production in order to hand them off to publishers. They went out of business in November, 2003.

The thing that many game developers don't understand about VCs is that they need to raise the funds that they turn around and invest in your company. They need to convince their LPs (limited partners) to give them millions of dollars in the hope that the VC will shepherd that money into the hands of entrepreneurs that will in turn build a company that will return 10x on that investment. The catch here is that every company the VC invests in will not be such a success. In fact most will fail, a few will break-even and even fewer will be big wins.

Sound familiar? This is the same model that the game industry works off of - News Flash: Most of the games that we love to play actually lose money! So here's the problem - if only 3 in 10 games make a profit a VC would need to invest in 10 game companies to hedge his bets. His entire firm may only have the capacity to invest in 10 companies across all sectors. Think less about money and more about the amount of time a VC has to spend with a given startup. Who cares you say - "The VC doesn't know jack about making games - we don't need that much of his time just his money". The answer is that his LPs care. They want to sleep at night knowing that the VC is watching over their money at work.

That brings us full circle and back to the article's original question:

The question I have is simple. Why is there such a mismatch between the capital needs of the video game industry and the investment that is going into it?

The answer is that the mismatch lies in the steamlined nature of VC firms (sure there are some big ones but most run mean and lean in terms of headcount) and the hit-driven nature of video games. If you could get the $25 million that that CEG was trying to raise (and you really need to multiply that number by 10 for next gen products) and invested in 10 game startups you would need to build a much different looking investment outfit then a typical VC firm. In addition to the standard fund raising and investor relation efforts you would also need a staff of producers and technical directors to work with the startup companies and you would need a team of marketing and sales directors to shop those companies to the publishers. In short you yourself would need to become a mini-publisher at which point you will be going up against EA, Sony and Microsoft.

After looking at this from both sides and bouncing it off of some of the top folks in both the VC and VG Publishing fields I came away thinking that the solution is to work within the existing publishing structure and find ways to fund more smaller, shorter and dynamic efforts.